The Case Against the Fed

May 27th, 2011

In 1913 the United States Congress passed the Federal Reserve Act which created a central bank for America. With its charter came the ability to create money and credit for the country. And so it did. By the end of the 1920s the Fed had inflated the money supply so much that the government was forced to revoke the right of Americans to trade their Dollars for gold. With great irony the Congress later gave the Fed, as one of its mandates, the job of promoting price stability. So just how is the Fed supposed to fight inflation via its ability to create it? Even on the surface something is amiss with this relationship. In The Case Against the Fed, Murray Rothbard exposes the self serving fallacies of the Fed to arrive at the ultimate truth: If you really want to fight inflation, then you need to eliminate its primary cause, the Federal Reserve itself.

Making a case against the Fed begins by debunking the notion of an optimum supply of money. Throughout the history of central banking, the public has been conditioned to believe that expert management of the money supply is critical to economic growth. And in the case of the Federal Reserve, it is too important a task to risk politicization via oversight. The claim by central bankers is that they are responsible stewards of the public interest. They do not suffer the temptations of politicians to merely print money for their own self interests. They instead carry out the critical task of expanding the supply of money at a rate to match the needs of increased production or population growth or some other stated factor.
On the surface such explanations sound reasonable and have certainly been effective over the years at deflecting questions about the Fed’s purpose. But why must the money supply be expanded at all? Money itself is not wealth but simply a medium of exchange. Wealth is represented by the underlying goods and services that money may be exchanged for. When a bank creates new money or credit, the amount of real goods and services do not increase proportionately. Rather, the ultimate purchasing power of all money is reduced. But therein lays the catch. Those who receive the new money first are able to claim a greater share of real goods and services as they are able to secure them at the original prices. Those who receive the new money last suffer higher costs prior to experiencing any potential increase in wages. The end result is not a net increase in real wealth but rather a net transfer of existing wealth.

The key to understanding the importance of the Fed in supporting the power and profits of the banking system is to first understand what Rothbard calls the inherent fraud of our fractional reserve system of banking. The nature of the fraud lies in the fact that at any given time a bank has more obligations than reserves in which to meet them – a literal Ponzi scheme. It is at all times insolvent and its ability to continue in operation relies on the public’s general failure to grasp this concept.

In times past, a run on the bank meant its end as its insolvency was exposed. Depositors seeking their money found out the hard way that only a small portion of what they deposited remained available for withdrawal. The vast majority of it had been loaned out. This is the fundamental conflict of our banking system, the enticement to loan out money that is claimable on demand in order to simultaneously generate additional profit.

This practice is not just lucrative for banks but highly inflationary as well. Each dollar deposited is available to spend, while at the same time it has been lent out to be spent. As long as the majority of the dollars are simply transferred from account to account within the same bank this scheme continues unnoticed. It is only in times of crisis that a loss of confidence results in a run on the bank. Depositors fearing that not enough money exists, race to redeem their deposits before the limited supply of reserves is exhausted.

Beyond the loss of depositor confidence there is one other limitation on a bank’s ability to expand credit beyond its reserves. When money is transferred from an account at one bank to an account at another, the corresponding transfer of underlying reserves could expose the insolvency in the same manner as a bank run. To counter to this, banks could attempt to act as a cartel and simply accept each others notes in exchange for actual reserves. But in practice this is difficult to achieve as it requires all banks to expand at the same rate in order to evenly distribute the risk involved in holding such notes.

These two limitations have been the Achilles heel of the fractional reserve banking system since its inception. The real purpose of a central bank is to shore up the vulnerabilities in the banker’s profit mechanism. By serving as the lender of last resort to the banking system, coupled with the sole legal right to produce new currency, the Fed has the power to stop a bank run from threatening the system. They also serve as an effective cartelizing agent by requiring that all banks keep their reserves on deposit at the Fed. By maintaining these reserves in the form of Federal Reserve Notes, the Fed can assure that all banks inflate their credit evenly and do not lose reserves to one another.

In the end, Rothbard’s case against the Fed reduces to the fact that it is nothing more than a legalized counterfeiter that stands ready to bail out the inflation machine of fractional reserve banking. The notion that it is somehow required to manage economic growth or to fight inflation is patently false. It is merely the capstone on a system that exists to do nothing more than transfer wealth from the many to the few.

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